Characteristics of preferred stock

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Multiple Classes of Preferred Stock

Most companies issue one class of common stock, but it is quite
common to see companies with more than one series of preferred
stock. Table 3–1 lists some of the different preferred stock issues of
Citigroup, Inc. (listed on the New York Stock Exchange).

Each class of preferred stock has different features. For example,
Citigroup’s preferred F series pays a dividend of $3.18 per
share with a yield of 6.3 percent at a closing price of $50.25 per
share and was down $0.25 from the preceding day’s closing price.
Citigroup has several cumulative preferred stock issues, which give
holders the right to receive all missed dividend payments before
common shareholders are paid. Convertible preferred stock can be
converted, by holders, into a fixed number of shares of common
stock of the underlying company. A call provision gives the issuing
company the right to call the preferred stock at a specific price
(normally a premium over its par value). These issues also might
be differentiated in their priority status with regard to claims on
assets in the event of bankruptcy.

Table 3-1
Different Preferred Stock Issues of Citigroup, Inc.

Prices as of July 6, 2006.

Claims on Income and Assets

Preferred stock has a preference over common stock with regard to
claims on both income and assets. Companies are required to pay
dividends on preferred stock before they pay dividends to common
stockholders. In the event of bankruptcy, preferred stockholders’
claims are settled before the claims of common shareholders. This
makes preferred stock less risky than common stock but more risky
than bonds because bondholders have priority in claims to income
and assets over preferred stockholders. Companies must pay the
interest on their debt, and in the event of a default, bondholders
can force the defaulting corporation into bankruptcy, whereas dividends
on preferred stock (and common stock) are declared only
at the discretion of the board of directors. In the case of multiple
classes of preferred stock, the different issues are prioritized in their
claims to income and assets.

Cumulative Dividends

Most preferred stock issues carry a cumulative feature, which is a
provision requiring a company to pay any preferred dividends that
have not been paid in full before the company can pay dividends
to its common stockholders. In other words, if the company fails to
pay dividends to its cumulative preferred stockholders, it will have
to pay all the missed dividends before the company can pay any
dividends to its common shareholders. A company that fails to
pay its dividends is said to be in arrears, which is defined as having
outstanding preferred dividends that have not been paid on a
cumulative preferred stock issue. Before the company can pay
dividends to its common stockholders, it would have to pay the
dividends in arrears to its cumulative preferred stockholders
first. This cumulative feature protects the rights of preferred stockholders.
A preferred issue that does not have a cumulative feature
is called a noncumulative preferred stock. Dividends on such stock do
not accumulate if they are not paid.

Convertible Feature

Some preferred stock issues have a convertible feature that allows
holders to exchange their preferred stock for common shares. The
conditions and terms of the conversion are set when the preferred
stock is issued. The terms include the conversion ratio, which is the
number of common shares the preferred stockholder will get for
each preferred share exchanged, and the conversion price of the
common stock.

For example, Chesapeake Energy Corporation issued a mandatory
convertible preferred stock issue that will automatically convert
on June 15, 2009, into a range of Chesapeake’s common stock (no
fewer than 7.1715 shares of Chesapeake’s common stock and no
more than 8.6059 shares depending on the then market price of
Chesapeake’s common stock). If the price of Chesapeake’s common
stock rises above the conversion price before June 15, 2009, holders
can convert at their option.

The decision to exercise the conversion option depends on
three factors:
* The market price of the common stock. It must be greater than
the conversion price for the holder to share in capital gains.
* The amount of the preferred dividend.
* The amount of the common dividend.

The conversion feature provides the investor with the possibility
of sharing in the capital gains through the appreciation of
the common stock, as well as the relative safety of receiving the
preferred dividends before conversion. If the preferred dividend is
much greater than the common dividend, holders would weigh
this into the amount of the appreciation as to whether to hold the
preferred stock or convert to common stock.

Call Provision

A preferred stock issue with a call provision entitles the issuing
company to repurchase the stock at its option from outstanding
preferred stockholders. The call price generally is more than the
preferred stock’s par value.

The call provision is advantageous to the issuing company
and not to the holder of the preferred stock. When market rates
of interest decline significantly below the dividend yield of the
preferred issue, companies are more likely to exercise the call provision
by retiring the issue and replacing it with a new preferred
stock issue with a lower dividend yield. Citigroup redeemed for
cash all the outstanding shares of its 8.4 cumulative preferred
stock series K at a redemption price of $25 per share plus accrued
dividends in October 2001. In January 2003, Citigroup called in its
adjustable-rate cumulative preferred stock series Q and series R for
a cash price of $25 per share plus accrued dividends.

When a preferred issue is called, the savings to the issuing
company represents a loss of income to preferred stockholders.
Thus not only do preferred stockholders suffer a loss of income
when their high-dividend-rate preferred stock issues are called in,
but the call provision also acts as a ceiling limit on the price appreciation
of the preferred stock. When interest rates decline, there
is an upward push on the price of high-dividend-rate preferred
stock issues, but the price of the preferred stock will not rise above
the call price. For example, if a preferred stock issue has a call price
of $55, potential buyers of the preferred stock would be unlikely to
pay more than this amount when interest rates decline significantly.
This is so because investors who pay more than this ceiling price
would lose money if the issue were called.

To entice investors to buy preferred stock issues during periods
of high interest rates, companies include a call protection feature.
This prevents the company from calling the issue for a period of
time, generally five years, but this varies. After the call protection
period, the issue is callable at the stated call price per share.

Participating or Nonparticipating

Participating preferred issues allow holders to receive additional
dividends (over and above regular dividends) if they are declared
by the board of directors. These additional dividends generally are
less than the extra amounts paid to common shareholders. The
majority of preferred stocks are nonparticipating.